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7.2.3 Common Stock or Partnership Interests

Unlike yields to maturity on debt or yields on preferred stock, the cost of common equity for specific companies or risk categories cannot be directly observed in the market. The cost of equity capital is the expected rate of return needed to induce investors to place funds in a particular equity investment. As with the returns on bonds or preferred stock, the returns on common equity have two components:

Dividends or distributions

Changes in market value (capital gains or losses)

Because the cost of capital is a forward-looking concept, and because these expectations regarding amounts of return cannot be directly observed, they must be estimated from current and past market evidence. Primarily two methods are used for estimating the cost of equity capital from market data:

1. Single-factor or multifactor approaches:

a. Build-up models

b. Capital Asset Pricing Model (CAPM)

2. Discounted cash flow (DCF) approach

a. Single-stage DCF model

b. Multistage DCF models

Capital structure components

Short-term notes Not technically part of the capital structure, but may be included in many cases, especially if being used as if long term.

Long-term debt YES

Capital leases Normally YES

Preferred stock YES

Common stock

Additional paid-in capital YES—all part of common equity

Retained earnings

Off-balance sheet options

Or warrants Normally YES

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